Category Archives for Weekly Newsletter

What’s on the Menu for This Week

That’s what Federal Reserve chairman Janet Yellen is doing, keeping us on the edge of our seats until 2:00 PM Wednesday, when the Open Market Committee’s decision on interest rates is announced.

Will she, or won’t she?

The bigger question is whether stocks will peak on the news, ending a torrid four-month, 30 handle upside move in the S&P 500 (SPY).

I bet she won’t, but then I have never been that good at predicting the needs of women.

Certainly the economic data is not there to justify a rise. And inflation is nowhere to be seen, the sole prerequisite for dearer money that Janet has told us she needs to see first.

In the meantime, a steady drumbeat of warning of an imminent stock market sell off from my old friends, George Soros and Carl Icahn, is rising to a deafening din.

Call them old fashioned, but equity price earnings multiple rising towards a nosebleed 20X against falling earnings, shrinking volume, and narrowing breadth does not scream “BUY” to anyone with a memory.

Yes, global quantitative easing and negative interest rates may suck in enough foreign money to squeeze a few more points of upside from the S&P 500. But you can chase those pennies with your money, not mine.

In the meantime, individual investors are voting with their feet. According to data released by Lipper Analytical Services, some $850 million fled equity mutual funds last week, the sixth consecutive week out outflows.

The money fled into municipal bonds, $1.2 billion worth. No doubt investors find the stratospheric 1.32% yields irresistible. I guess the IShares National Muni Bond ETF (MUB) is the modern equivalent of a mattress.

It all sets of my scenario of the high frequency traders triggering a few more stop losses to squeeze a few more points of upside, then stock rolling over and folding like a wet taco shell over the summer.

If that happens, US Treasury bonds will rocket to challenge century low 10-year yields of 1.36%. Fasten your seat belt, don your hard hat, and pass the ammunition!

I’m hearing that risk managers at all the major hedge funds are battening down the hatches and running scenario analyses until their mainframes melt.

Any other data releases will pale this week in the shadow of the Fed decision.

On Tuesday at 10:00 AM EST will be a yawn. The weekly Wednesday bond auctions should be well bid.

The Weekly Jobless Claims at 8:30 AM EST on Thursday will continue to peg numbers at four-decade lows.

It will be interesting to see if $50 plus oil will cause the Baker Hughes rig count to rise for a second week in a row at 1:00 PM EST on Friday.

A quadruple witching option expiration should provide the usual excitement at the Friday close as the plungers and market makers game the even money strikes.

If you have any questions on the above, you can call me via international radiotelephone on the Queen May 2 in the aft deck 10 Owner’s Penthouse Suite.

I should be somewhere in the mid Atlantic sipping my Dom Perignon sailing over the wreck of the Titanic.

We have had choppy action in the major indices this past week, In such an environment, the market often zigs when we expect it to zag. This unpredictable behavior naturally puts us on high alert because both Danger and Opportunity seem to arise quite suddenly.

We are either waiting to pounce or waiting for an ambush.

This is a stressful state of mind for a trader and it arises because we have allowed ourselves to get over-coupled with Mr. Market. Over-coupling means we are too reactive to the behavior of the other. (I was once in a relationship like that. How about you?)

In the over-coupled state of mind we tend to over-focus on details, as we look for clues about what’s going to happen next. There is a subtle shift in our trading method from clean execution toward trying to predict market behavior in order to lower risk. That’s a trap.

When we are over-coupled, we are primed to react quickly. Our thinking process becomes streamlined… but that’s not necessarily a good thing. The over-coupled trader is likely to make snap decisions that have little to do with one’s trading plan.

In the over-coupled state of mind, time is compressed because we shift to a brain circuit that bypasses the forebrain (the seat of executive function). Instead, our thinking, if you can call it that, shifts to the lightning-fast instinctual track of our reptilian brain.

This Fast Circuit is all about survival. It was developed to help us deal effectively with ambushes by predators. When you allow this circuit to be activating in your trading, you are telling your brain that you are back in a primitive, high risk situation and you need to prepare for an ambush.

Additionally, in an over-coupled situation our focus on micro-movements in price results in micro-managing trades, which degrades any edge we may have had from our pre-planned strategy. You won’t be able to stay in a trade to target.

Moreover, our response will often be disproportionate to the significance (amplitude) of the signal.. In other words, we start to trade noise. Then, trading becomes stressful, unproductive and mentally-emotionally exhausting. The harder we try the worse we do.

It’s possible to train yourself to stay in a different and more productive mindset while trading.

Many talk about the psychology of trading and how important it is to develop a mindset that is conducive to being consistently successful at this endeavor. However, there seems to very little written about how to actually live through the daily riggers of trading. How to live through the daily, weekly or monthly drawdowns that plague us … well daily, weekly, monthly.

Living through drawdowns is the key to successful trading, bar none. If you can’t live through a drawdown you will not be a successful trader. It’s that simple. Hopefully this article will help you to do just that.

Since this is such an important subject I will be addressing a different aspect of living through these times in the next few newsletters so I can expound upon each point.

What is a drawdown?

Notice the title of this article is not live through “a” drawdown but live through drawdowns – plural. And I’m not talking about the MAX drawdown, I’m talking about the drawdowns you will be in most of your trading career.

A drawdown is the dip between new equity highs in your equity curve, it’s as simple as that. So, by definition, you can see a trader will spend most of his/her time in drawdowns. Some traders think drawdowns are a rare event, or at most, a once a year or quarter event – but the fact of the matter is that traders will spend more than 75% of their time in a drawdown.

Here’s an equity curve of a very successful algorithm. The Green boxes are new equity highs. This is when your account is making more than it’s ever made trading this system. These are your feel good times. Now look at the Red line when it’s not in one of the green boxes, for this is “the rest of the story.” The red line is you living in a drawdown. I’m thinking 75% of your time in a drawdown may be a little too conservative and that it may be more.

So if you’re going to spend more than ¾ of your time in this quagmire called a drawdown, you need to learn how to live through it/them.

I have a list of 5 things that won’t make them easier but will help to navigate drawdowns a little more elegantly.

Know the drawdown numbers of every system you trade as well as you know your birthday.

This is not meant to be funny. Your ability to handle drawdowns, hands down, is dependent completely upon how mentally prepared you are for them. This means it’s crucial you know your system’s past Max Drawdown as well as you know your own birthday. However, just like that birthday, you should expect to visit a drawdown of equivalent size once a year then, an even bigger one sometime in the future.

If you’re trading, and consider yourself a trader, you need to be very aware of what will happen to your account during that drawdown. If you do, you will be mentally prepared and have the intestinal fortitude to stick with the program through these challenging times.

If you’re not prepared psychologically for the drawdown, you will make emotionally driven decisions at the worst possible time in the worst possible place. These emotional decisions lead to that trait all bad traders share – selling at the lows or its doppelganger, buying at the highs. How many of you have done that?

One of the most important benefits of trading with an algorithm is to eliminate those counterproductive emotional decisions. Please don’t offset that leverage by acting emotionally when in DD.

Next week we will talk about #2 Measure your Drawdown – watch this space!

Why should I use an OPG order and what the heck is it anyways?

Has this ever happened to you?

You place your market order to sell XYZ at the opening price. However, your trade doesn’t execute until 9:32 a.m. ET, and by then, the price is lower than it was at the market open. What happened?

If you mark your order as a DAY order, many brokers will hold these orders until the markets open before routing them to the exchange. Even in this age of split-second transfers, it can still take a few minutes for an exchange to receive and queue your order. Therefore, your order gets filled a few minutes after the open.

The opening price for a stock is calculated by taking all the pre-market orders and setting a price that satisfies the greatest number of buyers and sellers. That price then becomes the opening price. This is the reason why we often see gaps between yesterday’s closing price and today’s opening price.

So how do we tell our broker that we want to participate in the opening price by submitting our order prior to the open?

We use a different TIF (time in force) designation for our order.

Instead of using a DAY order we use an OPG order (when trading with Interactive Brokers). If you use a different broker, be sure to check with them as to how they indicate market on open orders. Some brokers use MOO instead of OPG.

Here’s an example of an order to sell 100 shares of MSFT at the open with Interactive Brokers. Notice that instead of using DAY, we use OPG.

An OPG order will be accepted if it is received by the exchange before 9:15AM (ET). The order can be cancelled after 9:15AM, but it cannot be edited. After 9:28AM, OPG orders cannot be edited or cancelled. If you are placing your trades the evening before, you should have no problems here.

Now keep in mind that if you use a LIMIT order with an OPG, if the order isn’t filled on the open, it will be cancelled. So for those portfolios that use LIMIT orders to exit positions, do not use the OPG designation. Use DAY instead.

There are no guarantees in life or trading. But by using the OPG designation for your market exits, you will find that your fills will more accurately reflect a stock’s opening price. And your number of bad fills will greatly decrease.

Believe it or not, we get calls all the time asking this one simple question, so we thought we would answer it quickly for you right now in this short article. There is one day once a quarter where the market (stock index futures contracts that is) does not seem to move very much. Guess what day that is? Yes, you’re right, it is the first day when the next (active) contract month starts trading.

I know this sounds basic, but most people that have not been trading for very long don’t know when to switch over to the next contract month. For experienced traders, a recap of when to switch over is good to keep in mind. Let me quickly recap what the four trading months are for the index futures contracts, such as the E-Mini S&P 500, Dow Futures, Russell, Nasdaq, etc. and exactly when to switch over to the next active contract month.

The four contract months are as follows: MARCH (H) JUNE (M) SEPTEMBER (U) DECEMBER (Z)

You want to switch over on the Second Thursday Of The Expiration Month. This means you start trading the March (H) contract the second Thursday of December. Start the June (M) contract on the second Thursday of March. Start trading the September (U) contract on the second Thursday of June. Start the December (Z) contract on the second Thursday of September.

That’s all there is to it. Most beginner traders do not know this though, that is why I decided to put this in here. This is obviously very important to know if your long-term goal is to trade for a living.

Option pricing is based on a variety of factors.

There are seven main components that affect the premium of an option. These are:

The current price of the underlying financial instrument.

The strike price of the option in comparison to the current market price (intrinsic value).

The type of option (put or call).

The amount of time remaining until expiration (time value).

The current risk-free interest rate.

The volatility of the underlying financial instrument.

The dividend rate, if any, of the underlying financial instrument.

Each of these factors plays a unique part in the price of an option. In most cases, the first 4 are pretty easy to figure out. The rest are often forgotten or overlooked. However, although they may be a little confusing, each is Important. For example, when it comes to trading with options, reviewing volatility levels can help traders determine the right options strategy to employ.

In addition, it is noteworthy to assess the current risk-free interest rate and whether or not a particular stock is prone to the release of dividends. Higher interest rates can increase option premiums, while lower interest rates can lead to a decrease in option premiums. Dividends act in a similar way, increasing and decreasing an option premium as they increase or decrease the price of the underlying asset. Also, if a stock were to pay a dividend, a short seller would be responsible for that payment. This means that a short seller in securities not only has unlimited risk of the stock price rising, but also is responsible for the dividends paid out.

Volatility

Volatility is one of the most Important factors in an option’s price. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. It significantly impacts the price of an option’s premium and heavily contributes to an option’s time value. In basic terms, volatility can be viewed as the speed of change in the market, although you may prefer to think of it as market confusion. The more confused a market is, the better chance an option has of ending up in-the-money. A stable market moves slowly. Volatility measures the speed of change in the price of the underlying instrument or the option. The higher the volatility, the more chance an option has of becoming profitable by expiration. That’s why volatility is a primary determinant in the valuation of options’ premiums. There are options strategies that can be used to take advantage of either scenario.

Liquidity

Options strategies must be applied in specific market conditions to be money-makers. Liquidity is one of these market conditions. Liquidity is the ease with which a market can be traded. A plentiful number of buyers and sellers boosts the volume of trading producing a liquid market. Liquidity allows traders to get their orders filled easily as well as to quickly exit a position.

The best way to discover which markets have liquidity is to actually visit an exchange. The pits where you see absolute chaos are markets with liquidity. As long as there are plenty of floor traders screaming and yelling out orders as if their lives depended on it, you will probably have no problem getting in and out of a trade. However, I tend to avoid the pits where the floor traders are falling asleep as they read the newspapers. These are obviously illiquid markets and it would not be a wise move to place an options-based trade there.

If you don’t have the ability to actually visit an exchange, you can still check out the liquidity of a market by reviewing the market’s volume to see how many shares have been bought and sold in one day. As a rule of thumb, I choose markets that trade at least 300,000 shares a day, although one million shares a day is even better. It is also vital to ascertain whether or not trading volume is increasing or decreasing. This kind of volume movement is studied to indicate turning points in market price action. You can also monitor liquidity by monitoring the buying and selling of block trades-orders of 5,000 shares at a time-by institutional traders.

LEAPs

Long-term Equity Anticipation Products (leaps) are options that don’t expire for at least 9 months and can have expiration 2 or 3 years out. Once an option’s expiration gets closer than 9 months, they become plain options again with an entirely new ticker symbol. Be this as it may, leaps are in every way an option. Their expirations are a long way off and that makes them prime candidates for long-term plays and secure bets for shorter-term trades.

For traders with a traditional buy and hold orientation, options usually carry with them the stigma of being short-term trading tools with tax consequences. leaps, by the very nature of their long-term expiration dates, help to overcome this stigma. It isn’t unusual for leaps traders to hold a position for more than a year. Plus, leaps have the added benefit of giving a trader significantly more time to be right about a market move.